CECL’s impact remains profound despite attempts at regulatory relief

The August 26th joint statement¹  from U.S. regulators²  does nothing to alleviate the significant effect CECL will have on the earnings, balance sheets and behaviors of lenders seeking to also confront an unprecedented credit crisis caused by the COVID-19 pandemic.

CECL³ , or the Current Expected Credit Loss framework, represents the most fundamental change in loan loss accounting in 50 years. Promulgated by FASB as a means of rectifying abuses from the last financial crises, CECL can increase the amount of capital held against loan portfolios by 300% or more. At the same time, CECL will substantially increase the volatility of capital and earnings since lenders are now required to project and book losses at inception over the entire length of a loan. Small changes in projection assumptions extended over long tenors will cause dramatic swings in loan loss reserves in many cases.

Compounding challenges of CECL implementation is its profoundly poor timing⁴. For most lenders with public reporting requirements, CECL implementation was required as of January 1st of this year with a first reporting date as of March 31st, 2020. The economic fallout from COVID-19 this year not only impacts the fundamental credit dynamics of lender portfolios, but also throws a big rock in the pond of historic data upon which many CECL loss models are built.

Further complicating capital management is the disparate impact of economic stress and CARES Act subsidies by industry, region and even loan type. For example, commercial real estate can be negatively impacted if tenants are concentrated in the hospitality or restaurant businesses but are performing quite well if catering to grocery or e-commerce warehouses. Similarly, businesses in geographies where shutdowns are being relaxed are performing relatively well compared to major urban centers where lockdowns continue. Assumptions made about the speed of recovery, PPP assistance or a “second wave” of health concerns are likely to create significant volatility in loss projections for some time.

Although yesterday’s announcement codifies regulatory relief telegraphed earlier in Notices of Proposed Rulemaking (NPRs), it does nothing to change the impact or timing of FASB’s accounting implementation of CECL. The three rules impacted by the August 26th announcement are:

1. A final rule that temporarily modifies the community bank leverage ratio, as required by the CARES Act;
2. A final rule that makes more gradual, as intended, the automatic restrictions on distributions if a banking organization’s capital levels decline below certain levels; and
3. A final rule that defers final CECL adoption for all regulated bodies to the end of 2022.

In theory, the regulatory relief for all banks sounds like a tremendous burden lifted, but in practice this announcement affords little benefit. For one, most banks originally required to comply in 2020 have already made the switch. Converting back to the legacy ALLL framework would require immense resources for only a temporary benefit. Further, since CECL is first and foremost an accounting change, the joint regulatory statement has no impact on reported financial disclosures to the public or even private shareholders. Finally, in a world of consolidation in which the number of regulated depositories diminishes each year, corporate strategy and governance must be planned and executed using CECL metrics.

All this means that CECL direction and impact remains unchanged by this announcement. Lenders, both public and private, are quickly discovering that having a robust CECL framework which allows for differentiated loss models that are appropriate for differentiated loan pools will allow for needed capital conservation, improved business planning and increased lending capacity starting today. Every lender, large and small, should be examining their CECL framework without delay.

_{¹ FDIC, Aug 26, 2020. ‘Agencies Issues Three Final Rules.’ Web. https://www.fdic.gov/news/press-releases/2020/pr20096.html?source=govdelivery&utm_medium=email&utm_source=govdelivery
 ² The FDIC, the OCC and the Board of Governors of the Federal Reserve System
 ³ CECL = Current Expected Credit Loss, a fundamental change in accounting for loan losses, leases and derivatives/hedging in the U.S. promulgated by the Financial Accounting Standards Boards (FASB) in topics ASC-326, ASC-815, and ASC-842
 ⁴ The complete required timing matrix for accounting implementation can be found here: https://www.fasb.org/cs/Satellite?cid=1176173615325&pagename=FASB%2FFASBContent_C%2FNewsPage}